Goldman Sachs' Five Questions for Bernanke

1. Will he indicate greater downside risks to the economic outlook in light of recent data? At the National Bureau of Economic Research (NBER) conference last week Chairman Bernanke highlighted the tightening in financial conditions as a risk to the outlook, and noted that the Fed might want to "push back" on a further tightening in financial conditions. A key question is whether he will put additional emphasis on downside risks at the testimony tomorrow in light of recent data. One the one hand, the economic data have been more mixed recently, after a string of positive surprises in June and early July. While survey data for July has continued to look encouraging--with further gains in the Empire manufacturing index and the homebuilders' index--our Q2 GDP growth tracking estimate has declined sharply. Following disappointing news on retail sales and inventories, we lowered our Q2 tracking to 0.8%. On the other hand, financial conditions have eased off their late June peak mostly on the back of more dovish Fed communication. Our financial conditions index (GSFCI) has eased by about 20 basis points since its peak on June 24, but remains tighter than earlier in the year. Given these conflicting signals we do not expect Chairman Bernanke to indicate greater downside risks to the economic outlook than last week.

2. Will he distance himself from recent comments on tapering? Bernanke stated in the June press conference that "if the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year." Although the minutes of the June meeting did not suggest that tapering in September is a foregone conclusion, we continue to believe that is the committee's baseline and the most likely outcome. We therefore do not expect that Bernanke will distance himself from his prior comments on tapering.

3. Will he repeat his statement that recent Fed communication is mainly about the "mix of instruments"? He stated at the NBER conference that tapering asset purchases was more a decision about the "mix of instruments being used to provide accommodation" rather than an issue of the level of "overall accommodation." Our interpretation of this statement is that the Committee could enhance the forward guidance further in the future. We would expect him to repeat this statement.

4. Will he talk about labor force participation in much detail? Bernanke argued at the NBER conference that the labor market is weaker than the unemployment rate suggests, in part due to depressed labor force participation. Specifically, he said that the current unemployment rate "overstates the health of our labor markets, given participation rates and many other indicators of underemployment and long-term unemployment." As a result, he argued, that highly accommodative policy was needed for the foreseeable future. We would expect him to reiterate this view.

5. Will he discuss the possibility of lowering the unemployment rate threshold? Chairman Bernanke has alluded to the possibility that the committee might lower the current 6.5% unemployment threshold twice in recent weeks. First, he stated in the post-meeting press conference on June 19 that the threshold might eventually move down. Amongst the factors the committee would take into account are whether inflation is still low and whether the unemployment rate at that point is representative of the state of the labor market. Second, he highlighted at the NBER last week the likelihood of unemployment falling below the 6.5 percent threshold before the Fed started to raise rates. Specifically, he said that "I would suspect that it may well be some time after we hit 6.5 percent before rates reach any significant level." We would expect Chairman Bernanke to strike a similar tone with regard to questions about the threshold at tomorrow's testimony.

and...

We expect he will:

(1) not indicate greater downside risk to growth despite mixed data;
(2) not distance himself from recent tapering comments;
(3) repeat his statement that recent Fed communication is mainly about the "mix of instruments";
(4) talk about labor force participation in some detail; and
(5) again allude to the possibility of lowering the 6.5% unemployment threshold.